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Beware Puerto Rican Bonds Hiding in Your Portfolio

Steven Goldberg, Contributing Columnist, Kiplinger.com

Why should you care what happens on the sunny Caribbean island of Puerto Rico? Because, for starters, one-quarter of open-end municipal bond funds have at least 5% of their assets invested in Puerto Rican bonds, says Morningstar. And the island, a U.S. territory, is an economic basket case.

See Also: Risks Growing in Municipal Bonds

Standard & Poor's Puerto Rico Municipal Bond index has plunged 19% since May 1. Because of falling prices, yields have briefly soared over 10%, and the Puerto Rican government scaled back plans to issue $3 billion in new debt before year's end (all returns in this article are through Sept. 13).

Just how bad is the commonwealth's economy? It has been shrinking steadily since 2006. Gross domestic product declined in July by 5% from the same month a year earlier. The jobless rate tops 13% (compared with a 7.3% unemployment rate in the U.S.). One-quarter of the population is on food stamps. Young, educated people are leaving for the mainland, where opportunities are better (Puerto Ricans are U.S. citizens). Partly due to the brain drain, Puerto Rico's population has declined for ten straight years.

The commonwealth of 3.7 million people is awash in debt. Outstanding muni bonds issued by the Puerto Rican government and government agencies total a staggering $53 billion. California and New York are the only states with more outstanding debt. On a per capita basis, debt is about $11,000, while per capita income is only $10,500--just over half that of the poorest U.S. state (Mississippi). Puerto Rican government pension obligations are about 90% unfunded.

Until recently, many municipal bond fund managers were eager to invest in Puerto Rico. The interest on its bonds is exempt from state and local taxes in the U.S. for most investors. And thanks to the terrible economy--and credit ratings just one notch above "junk"--yields are generous.

But stretching for yield is a dangerous game. Says Eric Jacobson, senior fund analyst at Morningstar: "Some of the funds that own Puerto Rico bonds are yield hogs." I'd go further: Managers who loaded up on these bonds should be fired--as should their supervisors.

As is so often the case, funds got away with their yield-hog game until the markets soured. When Federal Reserve Chairman Ben Bernanke spooked the bond market last May by talking about reducing the amount of monetary stimulus the Fed has been adding to the economy, munis nationwide plunged.

Investors have reacted to the selloff by yanking tens of billions of dollars from muni funds. That meant some of the funds loaded with Puerto Rican bonds had to sell them. Detroit's bankruptcy further worried investors in Puerto Rican bonds. Falling prices and investor redemptions have created a vicious cycle: The more prices fall, the more fund investors sell. That puts more pressure on Puerto Rican bond prices, so fund investors sell more. Where this ends is anybody's guess.

What funds own these bonds? As a percentage of assets, nine of the ten most Puerto Rico-heavy muni bond funds are run by Oppenheimer, and almost all are single-state funds. (State-tax-free funds can be a boon for residents of high-tax states, such as California and New York.) The nine funds had from 22% to 31% of their assets in Puerto Rico as of their last reporting period (the end of July). The single-state funds are for investors in Virginia, North Carolina, Maryland, Arizona, Massachusetts, New York, Pennsylvania and Michigan. (See a table of the 20 funds with the most exposure to Puerto Rican debt at the bottom of this page.)

Returns for these funds have been abysmal. During the past three months, eight of the nine Oppenheimer funds have lost 11% to 15%--almost enough to wipe out the previous three years of positive returns.

The award for the highest weighting in Puerto Rico, 66% of assets, goes to an unusual fund, Franklin Double Tax-Free Income, which invests solely in Puerto Rico and other U.S. territories, such as Guam and the Virgin Islands. The appeal of this fund is that investors can collect interest that is free of both federal and state income taxes without having to invest in bonds issued in their state of residence. That's particularly important for taxpayers in a handful of states that don't permit residents to treat interest from home-state bonds as tax-free. The kindest thing I can say about the fund is that it's closed to new investors. It has tumbled 15.7% in the past 12 months.

Other Franklin Templeton muni funds are also big investors in Puerto Rico. So are funds from Eaton Vance and Nuveen.

Not surprisingly, almost all muni funds run by Fidelity, T. Rowe Price and Vanguard have less than 1% of their assets in Puerto Rican bonds. These three fund shops all charge low fees, do good research and are conservative in their credit analysis.

What should you do if you own a fund with a big slug in Puerto Rico? I'd sell-- even now, after their recent losses. By piling into such a risky area, these funds have shown you what they're made of. Municipal bond investments are, in my view, meant to be low-risk. Puerto Rico is anything but.

20 Funds with the Greatest Exposure to Puerto Rican Bonds

© 2013 Morningstar, Inc.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.